Parametric insurance coverages against natural catastrophe risks, a new risk transfer solution in a world of climate extremes

In a world of increasing uncertainty, one thing is sure: bigger and more frequently occurring catastrophes are set to test the reliability of (re)insurance modelling in a world of climate extremes. So, climate risk, and more specifically natural disasters, has become a challenging issue for the insurance industry, since it involves potential extremely large losses. The private (re)insurance industry cannot continue to provide coverage against natural catastrophes, as it has done in the past without opening itself up to the possibility of aligning their underwriting policies, their models and benchmarks to capture the loss experience exacerbated by climate change. In such an environment, the future of catastrophe modelling with an ever-shifting spectrum of risk is most timely and it inevitably requires to be involved today in the creation of new risk transfer mechanisms in the developing world: the parametric insurance coverages. In this environment, the phrase “parametric insurance” has probably recently become a ubiquitous term in the (re)insurance world because it appears that nowadays the scope of the (re)insurance industry is to provide cover for previously uninsurable or hardly insurable risks, in any part of the world and with fast and transparent payouts. It has been presented how parametric coverages are contracts that make a payout to a beneficiary only in the event of an index exceeding or not a threshold linked to an external observable variable. Also, the composition of this alternative solution is very simple because it includes three main steps: collection of data from a provider, calculation of an index used for modelling and pricing, and the choice of the related payout function. Apart from the transparency of payout trigger, they do not need for loss adjustment of insured’s incurred losses. It is even true that there is the high chance that an insured party may not be paid when they suffer loss and/or that they may receive a payment when they have suffered no loss: the basis risk issue must be minimized. The purpose of the analysis is to replicate the functioning of a Weather Index Insurance product (WII) based on a rainfall index aiming to protect Indian farmers’ crop production against severe droughts or/and excess rainfall and the combination of the two events. The research has been conducted at macro level due to the impossibility of having reliable and detailed information about historical losses, sum insured, premiums and high-level agricultural conditions on the insurer side. Therefore, the main idea is to present how a WII works together with the importance of selecting proper parameters to minimize the basis risk, and how it protects the insured farmers against the adverse financial effects of crop failure. India has been chosen because the actual rainfall variations account for more than 50% of the fluctuations in all the Indian country’s crop yields. This research has used a weather index linked to cumulative rainfall measured in mm fallen in only four selected Indian states, for which three indexes have been proposed characterized respectively by three triggering events, which cover different combinations of rainfall categories. The relative indexes are the Total Annual Rainfall Index, which considers rainfall values on annual basis without differentiation according to seasonal periods, which is indeed considered in the Total Seasonal Rainfall Index considering the four Indian seasons and the last index is the Weighted Annual Seasonal Rainfall Index that is similar to the second one, but it is then weighted according to the different contribution that a specific season has to crop growth. Subsequently, it is difficult to choose the appropriate payout structure to capture the true correlation between rainfall and crop yield loss: timing and amount of rainfall during the various growth phases of a plant are very important for satisfying the soil water balance and therefore the ultimate yield. The case study has confirmed how weather- based crop insurance products can be an innovative and valid instrument against rainfall negative effects on crop production, especially in India as symbol of countries whose economy is based massively on agriculture and where the climate change plays a decisive role. In conclusion, parametric solutions should be implemented as a complementary instrument with respect to traditional covers thanks to their value proposition in the ability to cover uninsured risks and to overcome traditional insurance issues, such as the reduction of the protection gap. The current main application sector of this alternative risk transfer solution is the agriculture with a wide range of indexable weather risks, which are most applicable to highly correlated risks, such as drought and temperature, while localized risks, such as hail or fire, do not easily lend themselves to index insurance, even though it could be a hot debate for the future.